The world has been hooked on cheap money for years. We are now witnessing what withdrawal looks like.
Raising interest rates from zero has produced a historic fall in bonds, notes Bank of America’s strategy team, led by Michael Hartnett. This year’s losses rival the worst bond declines since the aftermath of two world wars (1949, culminating in the Marshall Plan, and 1920, coinciding with the Treaty of Versailles), as well as the impact of the Great Depression (with the failure of Creditanstalt, a major European bank, in 1931).
This is the product of the end of near-zero interest rates, with the Federal Reserve lifting its key policy rate by a total of three percentage points in 2022, including another 0.75 of a point last week. Equally important, this has pushed real, or inflation-adjusted, rates well above zero. Measured by inflation-protected Treasuries, the five-year real yield has risen to a positive 1.60 percent from a negative 1.61 percent a year ago, according to Bloomberg.
Dramatic bond revaluation puts “the world’s busiest trades” at risk, BofA strategists wrote in a client note: the dollar, US tech stocks and private equity. The threat of a “credit event” – the polite term for a crash – also looms.
The preconditions that led to the October 1987 accident are mostly present, they add. These include a volatile geopolitical context, abnormal US markets that far outperform the rest of the world, and a lack of international coordination. What is missing, for now, is a currency crisis.
But the volatility of the currency has increased, with the
US Dollar Index
rising to a 20-year high, creating major tensions for other currencies. The biggest loser: the British pound, as markets react violently to Britain’s plan to borrow to finance tax cuts. Japan has had to step in to support the falling yen for the first time since 1998, even as it tries to keep its interest rates low.
So far, the bond carnage has produced bear market declines of another 20% in the major stock indexes, apart from the
Dow Jones Industrial Average,
which is down 19.6%. Thus, to date, the declines have primarily reflected lower price/earnings ratios; the cuts in earnings forecasts are just beginning. Goldman Sachs strategist David Kostin has cut his year-end
target to 3600 from 4300, given that the higher rates merit a P/E multiple of 15 times an assumed $234 of S&P earnings per share in 2023 (or just below the Wall Street consensus of 240.46 FactSet dollars).
But Jason De Sena Trennert, who heads Strategas Research, sees a profit recession that could reduce S&P earnings in 2023 to just $200. Earnings recessions tend to happen twice as often as economic contractions, and would reflect faster increases in producer prices than consumer prices, he argues in a client report. However, the estimated 10% drop would be much smaller than the average drop during a recession. And the drop in earnings estimates could mean the next stage of the bull market is on the way, he concludes.
Using Goldman’s estimated 15x earnings projection and Strategas’ $200 implies an S&P 500 target of 3,000. That would represent an additional 18.8% haircut from Friday’s close of 3,693.23, which is already 23% below the benchmark’s closing high of 564796. on January 3.
Frequent readers of this space might recall that the S&P 3000 was also the forecast of the old barron’s Félix Zulauf, stalwart of the round table. He made this prediction last December, when the large-cap benchmark peaked near 4800. Since then, however, he has remained radio silent and, unfortunately, has not released an update.
As for BofA’s Hartnett, he suggests investors “grow” if the S&P 500 hits 3600, “bite” at 3300 and “gorge” at Zulauf’s 3000 target. More Fed rate hikes could increase pressure on stocks and other risk assets. Futures markets point to increases of another 0.75 percentage point in November and 0.5 point in December, to 4.25%-4.50%, according to the CME FedWatch site. That matches the Fed’s year-end projection.
But on Friday there was a big contrarian bet in the rarified world of options on rate futures. Someone made a bet that rates won’t rise as much as expected in December, John Brady, managing director of global institutional sales at Chicago broker RJ O’Brien, said in an email. This suggests that someone is preparing to break something, which usually happens when interest rates rise sharply.
Write to Randall W. Forsyth at firstname.lastname@example.org